Financial Crisis, Great Recession, Productivity Puzzle

Question 1

Why do financial crises occur (investors lose confidence in assets, so demand collapses for those assets) (2)

B) why is it bad?

Answer 1

Fundamental reasons

Bubble-related reality check

B) because these financial crises can spillover into the real economy (Financial accelerator)

Question 2

Why does the Wall Street Crash of 1929 & 2007/08 crisis warrant more scrutiny?

Answer 2

It was followed by a severe recession (i.e spillover to real economy), which doesn’t always happen after a crisis

Question 3

Timeline of the 2007/08 GFC crisis

Answer 3

HSBC warns US housing not as strong as believed.

Run on the rock - bank run following Northern Rock receiving EFA.

Banking sector writedowns - banks forced to incorporate housing market related losses into reported profit figures. (Public realise true scale of problem)

• US gov acts as lender of last resort
• Fannie Mae rescue - US gov rescues giant mortgage lenders by taking them into ownership after they reveal huge losses
• Lehman Brothers goes bankrupt - US refuses bailout
• US gov rescues insurance giant AIG
• UK gov rescues RBS & Lloyds, assuming huge deficit.

Finally 2009 - huge budget deficit (10 years to recover budget)

Question 4

What caused the GFC crisis (9)

Answer 4

Low interest rates (excessive risk taking)

Securitisation - converting illiquid assets into tradable securities to lend e.g CDS

Distorting compensation packages (short termism - bonuses based so go for short term gains)

Deregulation of financial services

Shadow banking e.g Hedgefunds - unregulated so take more risks

Failures of ratings agencies (AAA meaningless)

Sub-prime lending (lend to low credit score people)

Extreme leverage position of financial institutions

Collapse of housing and credit bubbles

Question 5

How were they ignorant (4)

Answer 5

“This time it is different attitude” - following success of inflation targeting

Didn’t learn from East Asian crisis

Too much faith in regulators in developed countries

Financial Conduct Authority (FCA) - did not focus on stability of financial system

Question 6

Areas where economic analysis is inadequate (3)

Answer 6

No satisfactory theory of bubbles and crashes (why they begin/end)

Banking in general equilibrium models

Models do not incorporate banking in a satisfactory way

Question 7

What shows how financial crises can spillover to the real economy

B) How did the crisis spillover to real economy

Answer 7

Financial accelerator (financial markets impact real GDP)

B) Low interest, UK debt (borrowing) remained high, and many defaulted, so FI suffered losses.

So became more reluctant to lend: credit crunch and increase external finance premium. Slowdown of economic activity.

Question 8

2008 recession

Where did send us back to in terms of GDP, and how long did it take to recover? And unemployment

Answer 8

6.1% fall in GDP - back to 2005 in terms of real GDP

Took 72 months to recover

Unemployment 5% to 8.4% - main concerns hysterisis, and REAL WAGE FALLING (EXPLAINED LATER)

Question 9

So this 2008 recession ended the period of Great Moderation 1992-2008.

What was it

Answer 9

16 years of stability (low/stable inflation, strong growth, low and stable unemployment)

Known as NICE decade:
Non-inflationary continous expansion

Question 10

How did The Great Moderation exist (5)

Answer 10

Structural change
Better macroeconomic policy
Central bank - (better monetary policy)
Good luck hypothesis - luck and policy combined

Question 11

1st reason for great moderation:
Structural change - 2 characteristics

Answer 11

Modern supply chains - better adapted to shocks

Financial innovation - easier to access finance & smooth consumption

Question 12

2nd reason for Great Moderation:
Better macroeconomic policy

Answer 12

Inflation targeting introduced - and successful (improved confidence and undertake investment)

Question 13

Back to the 2008 recession: What was the main concern for large unemployment (around 5 to 8.4%)

What happened for those STILL employed too?

Answer 13

Hysteresis - greater increase in longer term unemployment - skills depreciate

B) Pay squeeze - real earnings fell (inflation rose but nominal wages keep up i.e not pricing themselves out, look FC 32)

Question 14

III: Productivity puzzle

Productivity is important because a key source of growth and a country’s competitiveness.

How is productivity typically measured

Answer 14

Output per worker: Y/L

Question 15

What is a better measure, and why?

Answer 15

Output per hour (since Y/L not all, people work full time)

Question 16

Productivity trend overtime

Answer 16

Productivity slowdown - output per hour AND worker growth has been low

Around Great Recession 2008

Question 17

What happens to productivity during recessions - use Y/L! (2)

How is their irony?

Answer 17

• output declines (Y falls so productivity falls)
• employment and labour hours decline (L falls, productivity increases)

So opposing effects on productivity, in a recession???

Question 18

What does this imply

Answer 18

Productivity falls due to output falls, but should naturally return to its pre-recession upward trend since L falls

Since (un)employment lags output. (Brings productivity back up)

Question 19

Barnett et al explains 3 reasons for puzzle (opposing forces on productivity)

1 EXTRA!

Answer 19

Measurement error
Cyclical factors
More persistent factors

And real wages!

Question 20

1st reason for productivity puzzle:

Measurement error and Eval:

Answer 20

GDP (Y) or labour statistics (L) can be wrong

Eval: wouldn’t explain full extent of puzzle even if corrected

Question 21

2nd reason for productivity puzzle:

Cyclical errors

Answer 21

Labour hoarding -
L doesn’t fall as much as perceived: Firms retain more workers than necessary in a recession since costly to reduce workforce and reexpand once over. (spare capacity since more supply than demand)

Question 22

Evaluation of labour hoarding (2)

Answer 22

• Only likely during short recessions (for longer recessions costs of laying off is more tolerable)
• Employment actually increased while output fell during the 2nd phase of the UK prod puzzle.

Question 23

3rd reasons for puzzle:
Persistent factors - lack of capital deepening (explain pre-crisis & post-crisis view)

B) What happened in the GFC

Answer 23

Pre crisis- credit easy to access so resources may go to non-productive projects.

Post crisis - credit crunch so ditch even worthwhile projects.

B)
During recession , firms expected to substitute labour for capital (capital deepening). Didn’t happen, firms maintained or even expanded labour input (as mentioned in last FC), since real wage fell!

So lack of capital deepening! Investment declined overtime from GR 2008 onwards)

Question 24

Labour productivity expression in CD form

Answer 24

Y/L = A(K/L) to the 1-α

Question 25

Using this expression, what does productivity depend on? And relationship

Answer 25

• Total Factor Productivity (A) positive rel
• Capital employed (K) positive rel
• Labour - negative rel
• Capital to labour ratio overall is important K/L. (Also RMB input prices r and w)c

Question 26

Pessoa and Van Reenen’s view on productivity

Answer 26

Lack of capital deepening (shallowing) led to stagnant productivity puzzle. (Fall in K in previous CD expression)

Question 27

What is a key determinant in the productivity puzzle

Answer 27

Real wages

Question 28

Real wages in recessions

Answer 28

Typically, rigid, as output falls. However during the 2008/09 recession it did fall.

(Recall earlier we mentioned a pay squeeze)

Question 29

Why did real wages fall

And what was the main negative

Answer 29

Workers did not price themselves out, as in previous recessions. Firms can maintain employment comparatively more than past recessions (explaining the lack of capital deepening!)

Main concern - lower productivity (higher L).

Question 30

Why was labour cheaper though? Why did they not price themselves out? (3)

Answer 30

Fall in trade union power

More flexible contracts (firms weren’t fixed so gives them bargaining since lack workers lack job security)

High labour supply due to migration flows

Question 31

MPL formula

Answer 31

MPL = α(Y/L)

Question 32

How can we use MPL formula to create an adapted expression for productivity.

hint we have to make an assumption

Answer 32

Assume perfect comp (so MPL=real wage)
α(Y/L) = W/P

Then divide a to get
Y/L = 1/a (W/P)

Question 33

Recessions prior 2008 one.

A) Draw a graph following a fall in output.
B) What would happen to productivity using our alternate productivity expression?

Answer 33

A) Output falls, so labour demand falls. Shift left.

We assume real wages are rigid (unlike 2008 where real wages fell) , thus unemployment created (labour supply>labour demand)

B) Productivity remains unchanged, since a fall in Y is matched by a fall in L

Question 34

Evaluation of past recessions stylised approach

Answer 34

Too simple - ignores lagging indicator nature of employment. In reality we would get a brief fall in Y/L followed by a return to pre-recession level

(since employment lags behind output, so we will see short run effects of a fall in productivity following Y fall)

Question 35

Now consider 2008/09 recession diagram pg 72

A) graph following a fall in output

B) Productivity using alternative expression

Answer 35

Real wages no longer rigid (because no longer priced themselves out due to the various reasons as mentioned e.g fall in trade union power)

So a fall in output will reduce labour demand, however since no longer rigid, no unemployment, since workers just accept the lower wage.

B) Fall in real wages (W) reduces productivity.
(using expression Y/L= 1/A (W/P))

Question 36

In reality, are real wages flexible or rigid

Answer 36

Real wages unlikely to be either fully flexible or completely rigid, but inbetween.

Question 37

What is the main determinant of material well-being( standard of living) in the long run?

B) how much £ has been lost per average worker following the lost wage growth

Answer 37

Productivity

B) £10,700 a year due to productivity slowdown causing real wage growth fall

Question 38

Thatcher reforms to try “make Britain great again” (6)

Answer 38

Fiscal restructure (gov spending and tax) - underspent * tax reform badly designed

Privatisation

Competition strengthened

Pro EEC& EU single market

Industrial relations reformed

Innovation policy neglected

Question 39

What went wrong? (5)

Answer 39

Tax - reform badly designed

Infrastructure - underspent

Education - quality slowly addressed

Land-use planning - not reformed

Inadequate innovation policy

Question 40

Recommendations (3)

Answer 40

Increase pub/priv investment to address innovation policy to increase productivity (aim to increase public investment by 1% GDP annually, esp in key sectors e.g energy, housing, transport)

Promote efficient, resilient and inclusive economy (to address geographical inequality and opportunity)

Support knowledge sector, digitalisation and AI to drive efficiency

Question 41

How did government respond to the 2008 recession in their fiscal policy and monetary policy

These will be outlined in the next few topics

Answer 41

Fiscal
- VAT cut temporarily
- Vehicle scrappage scheme & help to buy
- Fiscal targets

Monetary
- interest rate cuts (until lower bound)
- unconventional MP (QE, funding for lending, forward guidance

Question 42

Keynesian approach: what do they focus on, who is involved, tool for intervention, and objective

Answer 42

Focuses on demand side - we have seen recession 2008.

Role for government - manage demand side e.g automatic stabilisers e.g unemployment benefits

Tool: Fiscal policy (tax and expenditure)

Objective: full employment

Question 43

Neoclassical view on intervention (around 1970s where Keynesian deemed not fully practical)

What is role of government

Tool

Answer 43

Minimal intervention (crowding out+ricardian eq)

Monetarists - role of government is to manage expectations. Control inflation by inflation target to give confidence so agents can stimulate economy!

Tool - monetary policy (manage quantity of money to decide price level to thus control inflation/price stability!)

Question 44

So Keynesian policy successful in 1960s, but not 1970 so neoclassical came. Was successful (shown by NICE)

But then GFC occured! (Remember minimum intervention i.e deregulation one of causes of GFC!)

So debate to which is the best! Both have failed